CAPTAIN DUANE E. WOERTH, PRESIDENT
AIR LINE PILOTS ASSOCIATION, INTERNATIONAL
BEFORE THE U.S. SENATE COMMITTEE ON COMMERCE, SCIENCE AND TRANSPORTATION
THE IMPACT OF FEDERAL PENSION AND BANKRUPTCY POLICY
ON THE FINANCIAL HEALTH OF THE AIRLINE INDUSTRY
October 7, 2004
Good morning. I am Captain Duane Woerth, President of the Air Line Pilots Association, International, which represents 64,000 airline pilots who fly for 43 U.S. and Canadian airlines. On behalf of ALPA, I want to thank the Committee for giving us the opportunity to present our views about the pension funding crisis facing the U.S. airline industry today.
Pension Woes Affected by Financial State of U.S. Airline Industry
It is impossible for me to discuss the pension issue without starting with the overall financial condition of the domestic airline industry, which remains quite poor. Our industry lost $23 billion in the last three years and is projected to lose another $4.3 billion in 2004. The immediate future does not look much brighter. Yields continue to deteriorate at an alarming rate, with domestic yields showing no sign of increasing. There is absolutely no pricing power in this industry Ė we canít even get a fuel surcharge to ease the burden of high oil prices.
The outlook remains grim. Recent projections for 2005 were for industry-wide losses of $300 million, but even those were based on fuel being at $35 a barrel. A $1 per barrel increase in fuel price results in an increase in fuel costs to the U.S. industry of $450 million a year. With fuel now hovering around $50 a barrel, industry analysts are hesitating to project what 2005 may look like.
For the airline industry, the economic factors are compounded by the lingering 9/11 effect: the use of commercial aircraft as weapons of mass destruction depressed the economy and reduced the number of passengers we fly, at the same time security taxes were added to our ticket prices and oil skyrocketed to historic market highs.
When we add to that the factors of historically low interest rates and poor stock market returns, we have a "perfect storm" for the pension woes we currently face. As a result of this witchesí brew, we are on guard for even more pension plan terminations and their attendant devastating consequences, potentially affecting hundreds of thousands of workers and their families. But despite this stark reality, ALPA believes these drastic results can be avoided with creativity and foresight Ė and appropriate legislative relief.
Pension Funding Crisis Created by the "Perfect Storm"
Much has been said and written about the "perfect storm" that has undermined the funding of private defined benefit plans in America. The two key elements of the "perfect storm" are historically low interest rates and poor returns in the stock market. Low interest rates impact pension funding because, as interest rates decline, the value of a pension planís liabilities increases. And when stock market returns move downward, the value of the planís assets decreases.
In a perfect world, a planís funding ratio would always equal 100%, meaning that the planís assets exactly equal the planís liabilities. But with historically low interest rates driving plan liabilities up, and investment performance driving plan assets down, the "perfect storm" has set the stage for funding disaster. The more the planís liabilities exceed the planís assets; the worse off is the planís funded status.
Contribution Volatility Created by "Deficit Reduction Contribution" Rules
If a planís liabilities exceed its assets, ERISAís regular funding rules for pension plans were designed, in general, to allow employers to make up that gap with more or less level contributions over extended periods of time. But when a planís funding gap drops down to a certain level, a special funding rule kicks in, requiring the employer to make much larger contributions over a much shorter period of time. This special contribution, known as a "deficit reduction contribution," makes it especially difficult for the employer to close the widening gap between assets and liabilities.
Logically, since a pension plan is a long-term proposition, it should be funded over the long term. This would require reasonably predictable, level, periodic contributions, similar to the way homeowners expect to pay their mortgage. But when a deficit reduction contribution is required, the pattern of required funding shifts in the opposite direction. That is, required funding amounts become extremely volatile, with extraordinarily large contributions required over very brief periods of time Ė the exact opposite of predictable, periodic contributions over a reasonably longer period of time.
A deficit reduction contribution is always required when a pension planís funded ratio for the year falls below 80%, and is often required when the planís funded ratio falls below 90%. Deficit reduction contributions are designed to bring the plan back to the 90% funded level, and while that is a laudable goal, the time the employer is allowed to get there is only three to five years. This is like asking homeowners to pay off their 30-year mortgage over only three to five years Ė far too short a time to meet far too large an obligation.
Because of this short time horizon, the contributions an employer must make to a plan when the plan is subject to the special deficit reduction contribution rule are often enormous, and can end up being unaffordable, especially when compared to the amount that would have been required if only the regular funding rules applied. The deficit reduction contribution rule was added to the funding laws in 1987 and strengthened in 1994, in an effort to help prevent underfunded plans from being terminated and their liabilities dumped on the PBGC. Although this is a desirable goal in theory, the strategy to achieve it backfires in the real world if the employer is unable to afford the deficit reduction contribution. In that case, the employer, now in bankruptcy, is forced to terminate the underfunded plan and dump liabilities on the PBGC anyway. No one wins, and the participant certainly loses.
This is precisely what happened in US Airwaysí first bankruptcy, with respect to the pilotsí plan. The pilotsí plan was the only pension plan of the four maintained by US Airways that was terminated. The Company was unable to emerge from bankruptcy without a distress termination of the pilotsí pension plan, due in large part to the deficit reduction contributions projected to be required over the next few years Ė and a significant portion of that burden was transferred to the PBGC, precisely opposite to the lawís intent.
Sadly enough, the US Airways pilotsí plan had been soundly funded just two years before the Company filed for bankruptcy. The plan went from being over 100% funded in 2000 to only 74% funded by 2002 Ė due to the "perfect storm" and the funding rules in place which allowed the corporation to bank payment credits due to high pension funding levels. Once the funding level decreased, the requirement for deficit reduction contributions kicked in. However, the Company could not afford to make those payments and emerge from bankruptcy with financing and a viable reorganization plan. As a result, the pilots acquiesced to the Companyís "distress termination" of their pension plan. Although a new defined contribution plan was established, it could not replace the benefits active pilots lost under the prior program and it provided nothing to restore what retired pilots had lost.
All told, the active and retired pilots of US Airways lost $1.9 billion in accrued benefits that were not funded by the plan and were not insured by the PBGC. This loss amounts to just over one-half of the $3.7 billion in total benefits that pilots had already earned as of the time the plan terminated.
Bargaining Efforts to Reduce Pension Costs
ALPAís pilots and leaders have not stood idly by and watched as these events threatening their pensions have unfolded. Since the beginning of this pension funding crisis, the pilots and our airlines have taken active and creative steps to explore all available means of reducing or delaying pension costs, within the bounds of current law.
Of course, there is only so much the parties can do through collective bargaining. Most significantly, the parties cannot agree to reduce the benefits that employees have already earned to date under a pension plan, pursuant to the "anti-cutback rule." Since accrued benefits cannot be reduced, the most that ALPA and the airlines can do in collective bargaining, in order to reduce future plan costs, is to agree on changes that reduce, or even eliminate, future accruals under the plan.
Several pilot groups have already made changes reducing the rate of future accrual under their plans, and other pilot groups are considering such changes. Last year, for example, the pilots at United Airlines addressed all three components of their pension plan formula. Under that plan, a pilotís benefit is based on three factors: the pilotís final average earnings, his or her years of service, and a multiplier. A substantial pay cut resulted in slashing a pilotís expected final average earnings. In addition, the number of years of service a pilot could earn under the plan was capped at 30. Finally, the multiplier was reduced by 10%. The result of these changes was a temporary freeze on accrued benefits for all pilots and a permanent freeze on accrued benefits for some pilots, including those who already had at least 27 years of service under the plan.
It is important to understand that while such changes will help reduce future pension costs, they cannot reduce the costs associated with benefits already accrued prior to the changes. Because of the anti-cutback rule, the most drastic plan change that the parties could agree upon is a total plan freeze. In that case, participants would not earn any additional benefits under the plan, but would be limited to the benefits they have already earned as of the date of the freeze. Short of a distress termination of the plan, a total plan freeze provides the largest possible cost savings to an employer, but the employer must continue to fund the benefits that were earned prior to the freeze.
Funding of accrued benefits under a frozen plan can be extremely burdensome, however, under the deficit reduction contribution rules. For illustration, let me review a situation involving one of the legacy airlines, one that we believe is typical of the funding results achieved by freezing the defined benefit plan. This airline compared the amount of contributions that would be required over the next 15 years if the plan remained unchanged, to the amount that would be required if the plan were frozen. Over the 15-year period, the contributions required if the plan were frozen would be less than 1/3 of the contributions required if the plan were not frozen. These are substantial savings, to be sure. But the curious thing is that, due to the deficit reduction contribution rules, fully 100% of these lower contributions would be due over the next five years only, with zero contributions required in the following 10 years, hardly short-term relief.
We believe this example stands as strong evidence that the current funding rules, with the poorly designed deficit funding contribution requirement and resulting volatility of contributions, are simply illogical and do not function as intended.
Administrative and Legislative Efforts to Allow "Restoration Funding"
Last year, in a joint effort, ALPA and US Airways asked the PBGC to restore the terminated pilotsí plan to US Airways, and allow pilotsí accrued benefits under the plan to be funded by the Company over a period of up to 30 years. Although the PBGCís regulations specifically allow for such "restoration funding," the PBGC determined it did not have authority to do so in this case and warned against establishing, from its point of view, a "bad" precedent.
Subsequently, ALPA and US Airways jointly sought legislation requiring the PBGC to restore the pilotsí plan. Although many Members of Congress sponsored or co-sponsored bills to accomplish just that, in the end, that measure did not pass.
Pension Funding Equity Act of 2004
In April 2004, Congress passed the Pension Funding Equity Act. In addition to provisions applicable to all defined benefit plans, the Act contains special relief for certain defined benefit plans maintained by passenger airlines. In general, the Act granted relief, for two years only (2004 and 2005 for most airlines), from a portion of the deficit reduction contribution otherwise due for those two years. We understand that most, if not all, of the eligible airlines have elected to use the special relief for their eligible plans. As you know, the temporary nature of the relief has the effect of exacerbating the plansí funding requirements in 2006 and beyond. We appreciate the fact that Congress is willing to work with us to fix this problem. Without further relief, the increased deficit reduction contributions required for 2006 and beyond will be even more costly.
The devastating consequences of more pension plan terminations in the airline industry can be avoided, if appropriate legislation is enacted now. We believe the current pension funding crisis is only temporary. We believe that, given sufficient time, interest rates will rise, stock market performance will improve, and airline profitability will return. Sound retirement policy should not allow an employer to break its pension promise to employees, just because of negative economic and financial conditions expected to last only a few short years. This is especially so when such negative conditions are viewed in the context of a pension plan, the duration of which is measured in decades.
So the simple cornerstone of our solution is to allow airlines to amortize their pension plansí unfunded liabilities over a longer term. We believe that allowing long-term amortization of the present funding gap creates a situation in which all stakeholders win.
First and foremost, it is a win for workers, who will have a greater likelihood of actually receiving the benefits they have already earned under their pension plans. After all, over the course of their careers, employees have given up direct wage compensation in exchange for the promise of deferred retirement benefits.
Secondly, it is a win for the PBGC, because it greatly reduces the chances of more distress plan terminations. A plan that is allowed to become well-funded over time will never be dropped on the PBGCís (and taxpayersí) doorstep.
Finally, itís a win for the airline industry and the traveling public. Of course, it will allow airlines to deliver the benefits they promised to employees. But just as importantly, it will allow the airlines to better manage their cash flow and prepare feasible business plans without being sabotaged by unpredictable deficit reduction contributions. A feasible business plan will, in turn, unlock the door to long-term capital financing of the airlinesí business needs and endeavors, and should, in the case of some legacy carriers, help them avoid bankruptcy altogether.
Under current law, the only way an airline can avoid burdensome pension costs is by entering bankruptcy and terminating the plans. But if more and more airlines choose to shed their pension liabilities in bankruptcy, it sets up the potential for the "domino effect," in which all the other legacy carriers are incentivized, or even forced, to file bankruptcy, in order to achieve the same cost savings and "level the playing field." We believe that providing relief from the deficit reduction contribution rules will go a long way toward removing the pension plan termination incentive to enter bankruptcy, and will, as a result, help prevent further bankruptcies in the U.S. airline industry.
Allowing airlines additional time to fund employeesí accrued benefits will also give the parties time to step back, review and in some cases completely alter the design of their retirement program Ė all without the threat of a distress plan termination hanging over their heads. Given the sufficient breathing room made possible by longer amortization of the defined benefit plan liabilities, airlines and employees can craft creative solutions that may provide secure alternatives to pure defined benefit plans. Each airline and employee group must create an individual solution to their individual pension challenge.
For some groups, but by no means all, the solution may lie in gradually shifting away from excessive reliance on defined benefit plans as the primary sources of retirement benefits, either by replacing them, or by devising combination plans with a larger defined contribution plan component. As they make this transition and with the longer-term amortization in place, some of the groups may be willing to freeze their current plans by mutual agreement with their management.
In summary, we believe our simple proposal to allow long-term funding will allow the airline industry the time it needs to undertake a strategic, deliberate approach that provides employees with a secure retirement, keeps defined benefit plans out of the hands of the PBGC, and maintains healthy airlines. Again Mr. Chairman, I appreciate this opportunity to appear before you, and I would be happy to answer any questions the Committee may have.